The Austrian state of Carinthia, a sub-sovereign entity, on the verge of bankruptcy

While everybody has been looking at Greece, another drama is unfolding right at the core of the eurozone - in Austria and Bavaria - where we are witnessing the failure of a large bank, and the possibility of a large sub-sovereign default - of the Austrian state of Carinthia.

For those not familiar with the tale of Hypo Alpe Adria and its bad bank, Heta, here is a short and incomplete summary of what happened (for German speakers there is an excellent, very entertaining video from two journalists of Der Stardard in Vienna, explaining what happened in great detail). This is our summary:

Hypo Alpe Adria was based in the Austrian state of Carinthia, and took a big gamble in eastern Europe last decade, but unlike other Austrian banks Hypo was a little more than reckless in its expansion policies and the choice of its business partners - gun dealers among them. The bank was also used by the former Carinthian prime minister Jorg Haider to fund various political activities, including an oil deal with Libya. Losses started to build up since 2006. In 2007, Hypo was bought by Bayern LB, one of the German Landesbanken in 2007, and after large losses emerged in the financial crisis, the bank was subsequently nationalised in 2009. A bad bank by the name of Heta was created last year with €11bn debt, most of which is guaranteed by the state of Carinthia, which is, of course, not in a position to fulfil this guarantee.

Over the weekend, the Austrian bank supervisor discovered a massive valuation hole in the assets of Heta that would have required the Austrian government to inject up to a further €7.6bn in capital, which is more that what they already put into the bank. The Austrian government refused, forcing the bank supervisor to declare a debt moratorium. This is now likely to trigger hefty losses for the bank's creditors: BayernLB is first in line, which has €2bn in claims.

There is now a big spat going on between Austria and Germany, or rather Austria and the free state of Bavaria, whose government said yesterday that the state of Austria is essentially insolvent, as reported by Der Standard this morning. The only solution to clean up this mess is through legal means, through various cases that are going in Vienna and Munich. (It seems like everybody is suing each other). The Austrian finance minister, Hans Jorg Schelling, said Austria would only be responsible for €1bn in federal guarantees, but not the Carinthian ones. It was now up to the financial supervisor to bail in the creditors.

What we found quite amusing in this morning's report in Der Standard is how Austria's chancellor Werner Faymann is playing this - nothing to do with me: I'll leave this to the central bank, the finance minister and the supervisor.

Essentially what is happening now is that the declaration of the moratorium is triggering a bail-in process, as opposed to an insolvency process. This is why everybody in Austria (though not in Bavaria) meticulously avoids the term insolvency or bankruptcy. There has been a political debate going on inside Austria whether to force Heta into insolvency - though this would have raised big issues about the solvency of the state of Carinthia as well - which are now bypassed through the bail-in procedure. The Caranthians say, can't pay, won't pay, and are very happy about the bail-in.

Austrian television ORF offers some more details. It quotes the head of the bank supervisor as saying there were only bad solutions now. Auditors found a valuation gap of between €4bn and €7.6bn, mainly due to the correction of property assets in eastern Europe. The report noted that a capital increase of such size would have made it impossible for the Austrian government to announced a planned tax cut, which costs a similar amount. The debt moratorium starts right away and is to last until May 2016, at which point there will be a resolution procedure. What this procedure means is that creditors will be bailed in for the first time. A bankruptcy procedure is still conceivable.

In its coverage of the story, Frankfurter Allgemeine writes that for the first time an Austrian federal state could end up in bankruptcy. As part of the resolution process, Carinthia could end up in an insolvency procedure, which would be the only way to absolve the Austrian taxpayer from the massive liabilities that have built up.

Our other stories

Our other coverage includes a look forward to Greece's next funding deadline; what's happening to eurozone inflation; what the ECB's minutes can and cannot tell us; and commentators being glum about the eurozone.

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